I can’t tell you how many times I’ve read articles about underfunded pension systems that are “on track” to be fully funded in x # of years. The most recent one claims that the fund will be stable in 22-years. However, what they fail to discuss are the actions required to achieving a fully funded status. First, the plan sponsor must make all annual actuarially determined contributions, which usually increase every year. Second, the assets must earn the actuarially determined ROA consistently for the next 22 years. But those are big ifs, especially when one looks at the fact that we are at historic lows in US interest rates and at historic highs in equity markets on basically any valuation tool.
What is the probability that the ROA will be achieved? Furthermore, the sequencing of returns can play a meaningful role in whether the return objective is met, especially since this is a closed plan that will have greater outflows tomorrow than 20 years from now. What this plan needs to do is to secure the promised benefits for the next 10 years or so. This action will insulate the plan from adverse market conditions that would harm the plan’s alpha assets. Buying time for these growth assets permits them to grow unencumbered, as they are no longer a source of liquidity.
Buying time would enhance the probabililty of achieving the actual ROA of these growth assets since they are not diluted to make benefit payments. The history of the S&P 500 tells us that dividends reinvested account for 48% of the total return on a rolling 10-year horizon since 1940 and it is even greater for 20-year periods.
Actuaries do a terrific job despite all of the uncertainty in forecasting benefit payments and expenses far into the future. But they aren’t magicians. There should be an expectation built into their forecast that not all of the inputs will be achieved as predicted. We’ve seen this situation play out time and time again. Given this understanding, perhaps a greater emphasis should be placed on the contributions, which reduces the reliance on markets thus improving the likelihood of success. Just a thought!